The Causes of Economic Hardship for the Middle Class

January 31, 2007, Testimony of Dean Baker before the Ways and Means Committee (House of Representatives)

I want to thank Chairman Rangel for the opportunity to present my views on the key factors obstructing economic progress for the middle class. Chairman Rangel is correct in making this question a central focus of the Ways and Means Committee’s agenda for the next two years. As we know, the quarter century following World War II was a period of rapid economic growth, with the benefits being widely shared by groups all along the income ladder. Since about 1980, the economy has experienced healthy growth, but the gains have largely bypassed those at the middle and bottom. Congress must understand the causes of this growing gap in income and wealth in order to design policies to reverse it.

I will argue that the upward redistribution over the last quarter century was primarily the result of policy changes and not simply the natural workings of the market. Specifically, the federal government pursued policies that tended to benefit corporations and better educated workers at the expense of most of the working population. There are many areas of public policy in which it is possible to identify an upper class bias. I will focus on the four areas that I consider most important:

1) Trade and Immigration. The federal government has pursued policies in this area that had the effect of putting workers without college degrees in direct competition with low-paid workers in developing countries. At the same time, it has largely protected the most highly educated workers (e.g. doctors, lawyers, accountants) from the same sort of competition. The predicted result of this asymmetric opening of trade is the sort of upward redistribution that we’ve seen over the last quarter century.

2) Federal Reserve Board Policy. The Federal Reserve Board has pursued an aggressive anti-inflation policy over the last quarter century, largely ignoring its legal mandate to target full employment, which is defined in the law as 4.0 percent unemployment. The Fed’s main weapon for controlling inflation is higher unemployment, which has the effect of putting downward pressure on wages. The workers who are most affected when the unemployment rate rises are those at the middle and bottom. Sales clerks and manufacturing workers are far more likely to be laid off in a downturn than doctors or lawyers. There is also an important racial dimension to this issue. If the overall unemployment rises by 2.0 percentage points because of the Fed’s efforts to contain inflation, the unemployment rate for African Americans is likely to rise by 4 percentage points, while the unemployment rate for African American teens would rise by close to 12 percentage points.

3) Labor-Management Policy. In the last quarter century, corporations have become far more aggressive in confronting unions, especially in obstructing efforts to organize. It is now standard practice for management to simply fire any workers who are thought to be involved in an organizing drive. While firing workers for union activity is illegal, the sanctions are too small to discourage lawbreaking. Largely as a result of management hostility, unionization rates in the private sector have fallen to just above 7 percent from more than 20 percent back in 1980. De-unionization has substantially lowered wages for workers without college degrees.

4) Corporate Governance. For a variety of reasons, the factors that constrained the behavior of CEOs and top corporate management have largely broken down. As a result, these insiders have unprecedented ability to plunder corporations to serve their own interests. CEO pay for Fortune 500 companies now averages almost 300 times the pay of an average production worker. Such exorbitant salaries not only take away money from shareholders and workers, they also set benchmarks for the rest of the economy. As a result, it is now common for top executives in institutions like universities, non-profit hospitals, and even private charities to earn salaries in the high six figures.

A fifth topic that I will mention briefly is health care costs. Per capita health care expenditures in the United States already exceed $7,000 a year, or $28,000 for a family of four. In just over a decade, per person costs are projected to exceed $15,000 a year. There is no way that even a middle income family can pay these sorts of health care costs and still have enough money left over to sustain a reasonable standard of living.

It is essential that health care be reformed in a way that contains costs. The United States is the only country in the world that faces such out of control costs. Other wealthy countries pay less than half as much per person for health care and enjoy longer life expectancies. Surely, we can find a better way to run our health care system.

I will address each of the first four issues in more detail, but there is one basic theme that I will emphasize throughout my testimony. The upward redistribution that has taken place over the last quarter century did not just happen – it was a process that was aided and abetted by government policy.[1] While considerable attention has been placed on the regressive tax cuts of the current administration, the regressive policies that led to a redistribution of before-tax income have had a far more important effect on the lives of the middle class.

Trade and Immigration Policy

Over the last quarter century, administrations of both political parties have pursued a variety of trade related measures that have had the effect of placing less educated workers in direct competition with their counterparts in the developing world. This effect has been felt most intensely in manufacturing, where an explicit goal of trade agreements like the North American Free Trade Agreement (NAFTA) has been to make it as easy as possible for U.S. corporations to invest in manufacturing facilities in the developing world and then export their output back to the United States. Since workers in the developing world are paid far less than U.S. workers, this competition places downward pressure on the wages of manufacturing workers in the United States. Manufacturing has historically been an important source of relatively well-paying jobs for workers without college degrees, therefore the loss of jobs in this sector to imports, and the downward pressure on the wages of the workers remaining in the manufacturing sector, has placed downward pressure on the wages of workers without college degrees more generally.

The downward pressure on the wages of U.S. workers is not an accidental outcome of our trade policy: to a large extent it is the point of that policy. The gains from trade result from being able to purchase goods and services at lower prices from foreign producers. The predicted result from this trade is that the income of the workers who make products that compete with imports will fall, as has been the case. While this benefits consumers who pay lower prices, those who see their wages fall as a result of import competition are likely to end up as net losers, since their pay will fall by more than they save by consuming cheap imports.

Even if we want to see the United States trade more with the rest of the world, there was nothing inevitable about the trade policy implemented over the last quarter century. A series of decisions was made to place manufacturing workers in direct competition with workers in the developing world. To do this, trade agreements have included detailed rules for foreign investment in developing countries that protect it from nationalization, restrictions on repatriating profits, or other actions that could jeopardize the profitability of these investments. These trade agreements also imposed rules that prevent the United States from imposing tariff or non-tariff barriers that obstruct the importation of manufacturing goods to the United States.

However, the developing world does not only have manufacturing workers who are willing to accept lower pay than their counterparts in the United States. It also has doctors, lawyers, accountants and other professionals who would be happy to work for a small fraction of the pay that U.S. professionals receive. While these professionals in the developing world are not generally trained to U.S. standards, this is largely due to the fact that they have little reason to train to these standards. Immigration and licensing restrictions would still make it very difficult for them to ever practice their profession in the United States, even if they attained U.S. levels of competence.

Instead of focusing on trade in manufactured goods, U.S. trade negotiators could have pursued trade agreements that would have facilitated a process whereby professionals in developing countries could train themselves to meet U.S. standards and then freely practice their professions in the United States. This would have led to enormous gains to U.S. consumers and for the economy as a whole, through a process that equalized income. For example, according to data from the OECD, the compensation of physicians in the United States exceeds the compensation of physicians in Western Europe by an average of more than $100,000 a year.[2] (This is net of costs such as malpractice insurance.) The United States has 800,000 practicing physicians. This means that if free trade in physicians’ services could bring the cost of physicians’ services in the United States down to the level of West Europe, it would save consumers $80 billion a year (almost $300 per person) in health care spending.

It is possible to tell similar stories about the gains from freer trade in other highly paid professionals like law, dentistry, accounting, even economics. Trade agreements could have been crafted to bring down the wages for the highly paid professionals in these areas, allowing for large gains to consumers. However, U.S. trade negotiators instead pursued trade agreements that placed downward pressure on the wages of less educated workers, leaving our most highly educated workers largely protected from international competition. (I have focused on inequality among wage earners because this has been the largest source of redistribution from trade. Over the last decade, wage and profit shares have remained reasonably stable even as trade and the trade deficit have exploded.[3])

Immigration is part of this same story. Immigrant workers have been an extremely important factor in many sectors of the U.S. labor market over the last quarter century, competing primarily with less educated workers. While many of the jobs that are primarily filled by immigrants are extremely unpleasant and low-paying, this is largely a result of the fact that employers can find immigrant workers willing to take these jobs. In West European countries, many of these same jobs offer much higher pay and better working conditions because employers do not have the same access to immigrant workers. Therefore they have to improve conditions enough to attract native workers.

In the case of immigration, as with trade, consumers benefit from having access to lower cost immigrant labor. Restaurants and hotels can charge lower prices as a result, and our farm goods cost less because immigrants are willing to work in the fields for much lower wages than their U.S. born counterparts. But the U.S. workers who might otherwise hold these jobs end up as losers.[4]

The current policy on immigration, with sporadic enforcement of immigration laws, also helps to ensure that it is only less educated workers who face substantial competition from immigrant workers. Relatively unskilled workers in the developing world may be willing to take the risks associated with working without proper documentation in the United States (and also endure a dangerous border crossing). However, a well-educated professional in the developing world is unlikely to take the same risks, even if they could potentially earn a much higher salary in the United States. Of course, the enforcement of licensing standards for professionals in the United States also makes it far more likely that a doctor or lawyer who tried to practice their profession in the United States would face deportation than a dishwasher or custodian. In short, as is the case with trade, we have implemented an immigration policy that is designed to largely protect the most highly educated workers.

There is one other important policy issue on trade that is worth mentioning in this context. Over the last decade, both the Clinton and Bush administrations committed themselves to a high dollar policy. This policy has led to a huge trade deficit. At present, our trade deficit exceeds $800 billion a year, more than 3 times the size of the federal budget deficit. The high dollar policy, and the resulting trade deficit, further tilts the playing field against less-educated workers. A high dollar makes imports into the United States cheaper and exports from the United States more expensive. Most economists estimate the over-valuation of the dollar in the range of 20 percent to 40 percent. This is equivalent to having a subsidy of 20 percent to 40 percent on imported goods, and imposing a tariff of the same size on good exported from the United States to other countries.

As with the measures noted above, a high dollar benefits consumers by making imports available at a lower cost. However, it disadvantages the less educated workers who produce the goods that compete in world markets. Here also it is important to remember that the basket of items that are subjected to international competition is the result of policy choices. We could have chosen to subject our doctors and lawyers to international competition, in which case they would be the losers from a high dollar policy. Instead, we forced our autoworkers and custodians to face international competition.

Federal Reserve Board Policy

Monetary policy is usually discussed as being a purely technical matter, with the Federal Reserve Board trying to pursue an interest rate policy that keeps inflation under control, while also sustaining high levels of employment. In fact, the Fed’s decisions have huge distributional implications. It fights inflation by raising interest rates. Higher interest rates are expected to slow the economy, reduce the rate of job creation, and thereby raise the rate of unemployment. Higher unemployment in turn puts downward pressure on wages. By slowing wage growth, the Fed can keep inflation in check.

While few economists would disagree with this basic story, it is important to realize that the Fed’s anti-inflation policy does not affect everyone equally. When higher interest rates lead to job loss, it is more likely to be a sales clerk or manufacturing worker who loses their job rather than a doctor or lawyer. The unemployment rate for less educated workers rises disproportionately when the economy slows, and it is these workers that will feel the most pressure to lower their wages.

There is also an important racial dimension to unemployment. The unemployment rate for African Americans tends to be twice the overall average, while the unemployment rate for African American teens tends to be about six times the overall average. This means that if the overall unemployment rate rises from 4 percent to 6 percent, this is likely to mean a rise in the unemployment rate for African Americans from 8 percent to 12 percent, and a rise in the unemployment rate for African American teens from 24 percent to 36 percent.

In the years since 1980, the Federal Reserve Board has been far more focused on containing inflation than it had been in the prior 35 years. One result has been that the unemployment rate has been on average higher in the last quarter century than in the earlier post-war period (unemployment averaged 5.6 percent from 1948 to 1980, compared to 6.2 percent since 1980). It is striking to note that the only period in which workers at all levels of the wage distribution sustained strong wage growth was between 1996-2001, when the unemployment rate averaged 4.7 percent, and in fact fell as low as 3.9 percent for five months in 2000.[5]

Whatever the merits of the Fed’s anti-inflation policy, it is important to remember that it has a cost, and that this cost is borne disproportionately by less educated workers. Even those who agree with the policy must recognize the burden it imposes on those least able to afford it.

Labor-Management Policy

In the case of both trade policy and monetary policy, the changes leading to an upward redistribution of income were the result of explicit policy shifts. However, in labor-management policy, the main issues have been enforcement and the failure to respond to a change in behavior by employers. While there have always been conflicts in labor-management relations, the 30 years following the end of World War II were a period of relative peace, with management accepting the right of workers to form unions. Unions used their bargaining power to ensure that workers got their share of productivity gains, but they also often cooperated with management to try increase the productivity of their members.

Labor-management relations took a marked turn for the worse in the 80s. With the Reagan administration setting an example by firing striking air traffic controllers, many employers embraced the tactic of threatening striking workers with permanent replacements who would take their jobs.[6] This made strikes a far less effective weapon, since workers knew that in many cases they were risking their jobs. While there were efforts to pass legislation that would make it more difficult to fire striking workers, Congress has thus far done nothing to discourage the practice.

The other major change in employer behavior has been the use of aggressive campaigns to prevent unions from organizing. While employers may have always tried to prevent their workers from joining a union, they were more likely to respect the law in the years prior to 1980. In the last quarter century, employers have taken advantage of the fact that the sanctions are trivial for firing workers who are trying to organize a union.[7] A recent study by the Center for Economic and Policy Research, using data on wrongful firings from National Labor Relations Board, concluded that close to 1 in 5 workers involved in a union organizing drive can expect to be fired.[8]

The result of this growing hostility of management to unions, and the failure of the government to impose effective sanctions, has been a sharp drop in the rate of unionization in the private sector, from more than 20 percent in 1980 to just over 7 percent in 2006. While many have attributed this drop in large part to changing attitudes towards unions among workers, it is important to recognize that there has been no comparable decline in unionization rates in the public sector. The unionization rate in the public sector remains over 36 percent, with no downward trend during the last quarter century. The most obvious difference between the private and public sectors is that it is much more difficult for managers in the public sector to fire workers for organizing. In the absence of the extreme hostility from management, it is reasonable to believe that the unionization rate in the private sector would be comparable to the 36 percent figure for the public sector.

Corporate Governance

As has been widely reported by the media, the compensation of top executives has exploded over the last two decades. It is common for CEOs of major corporations to earn annual compensation in the tens of millions of dollars. In extreme cases, annual compensation packages have run into the hundreds of millions of dollars. While there is no obvious change in government policy that has led to this explosion in CEO pay, clearly the government has not effectively responded in a way that could contain pay for top executives.

The issue of CEO pay raises basic questions of corporate governance. The CEO and other top management are typically better situated to control a company than its diverse shareholders. The CEO will usually have close allies among the corporate board, many of whom are likely to owe their board seat to the CEO. This means that when the board, or a compensation committee selected by the board, decides the CEO’s pay, they may not have the interests of the shareholders as their top priority.

While shareholders could in principle organize to limit CEO pay, it is very difficult to bring such a diverse group together (especially since corporate bylaws typically allow management to count unreturned shareholder proxies as supporting its position). The gains to shareholders from such action will also be relatively limited. Even in the most extreme cases, CEO compensation is unlikely to come to more than 10 percent of the profit of a major company in a normal year. If shareholders believe that CEO pay is too out of line, they most likely would just sell the company’s stock.

It is not entirely clear what set of factors led to the explosion of CEO pay, but the government certainly does have the ability to change the rules of corporate governance in ways that might more effectively contain CEO pay. It is important to realize that the government already imposes a long set of rules on corporations in order to limit the likelihood that management, or one group of shareholders, will use its power to unfairly profit at the expense of other shareholders. For example, laws of corporate governance prohibit discrimination against minority shareholders. This means that a group of shareholders cannot gain control of the corporation and only pay dividends to itself. The government also has extensive rules on disclosure of information on profits and liabilities to ensure that market participants have full knowledge of a company’s financial situation.

In this vein, it can be argued that Congress failed to adjust the rules of corporate governance as the forces containing CEO pay collapsed. It can rewrite the rules of corporate governance in a way that redresses this imbalance. For example, Congress could require that CEO compensation packages are sent out for shareholder approval at regular intervals. It can also prohibit management from counting non-returned proxies as supporting its position in these votes. Congress could even change the rules on board liability so that board members can more easily be sued by shareholders if they fail to make reasonable efforts to contain CEO pay.

While it is not clear what set of policies would be optimal in the current environment, the point here is that Congress has always recognized the need to set rules of corporate governance that prevented insiders from exploiting their position. These rules are no longer accomplishing this task and therefore need to be changed.

As noted earlier, excessive CEO pay is not only a problem because of the resources it drains from corporations. The huge paychecks received by CEOs set standards that come to be applied in other sectors of the economy. This leads to extraordinary salaries for top executives in other institutions as well. The high salaries earned by hospital executives, university presidents, and other top management positions must come at the expense of either the pay of workers lower down the pay ladder or be passed in higher costs for the services provided. Either way, the exorbitant salaries for top executives outside of corporations, like the salaries of corporate CEOs, lead to more inequality in the economy.

Moving Toward Shared Prosperity

The discussion of the factors that have led to growing inequality points to many of the policies that would be important in reversing this trend. At the top of this list is a trade policy that focuses on bringing down the wages of the most highly educated professionals, thereby reducing the cost of health care, college education, and other services provided by the most highly paid workers. If future trade agreements were structured to make it as easy as possible for students in India, Mexico, and other developing countries to educate themselves to U.S. standards and then work in the United States as doctors, lawyers, and accountants, it would lead to huge gains for consumers and the economy, while leading to a much more equal distribution of income.[9]

It is also important that the dollar be brought down to a sustainable level. This will happen in any case, but it is better that it happen sooner rather than later, before the country builds up more foreign debt and loses more of its manufacturing capacity. It is important to recognize that the Treasury has the power to unilaterally lower value of the dollar. In the extreme case, it can set a lower value for the dollar, just as the Chinese government has set a low value for the yuan. The Treasury can seek to negotiate a path towards a lower dollar as it did with the Plaza accords in the mid-eighties. However, the willingness to take unilateral action to lower the dollar will be more likely to persuade other countries to cooperate in easing down the value of the dollar.

As to the Fed’s monetary policy, it is reasonable for the Congress to use its oversight authority to insist that the Fed take the law’s target of 4.0 percent unemployment seriously. Furthermore, the Fed has chosen to ignore asset bubbles (the stock market bubble in the 90s and the housing bubble in the current decade). These bubbles have increased inequality and the collapse of both bubbles (especially the housing bubble) have serious consequences for the middle class.

Congress can take steps to counter the aggressive anti-union stance taken by management in the last quarter century. For example, it can allow workers to form unions through the card check process, as laid out in the Employee Free Choice Act. It could also increase the sanctions against employers who are found guilty of firing workers for union activity. For example, it can require that employers pay legal fees, as is done in civil rights cases.

Finally, as noted earlier, Congress can adjust the rules of corporate governance to reinstate checks on the insider power of CEOs and top management. The exorbitant pay packages of CEOs are a drain of resources from the rest of society. They also encourage others to exploit their positions of power for personal gain.

The pattern of economic growth over the last quarter century is disturbing for those who envision a society in which everyone can benefit from a prosperous economy. However, there was no reason that income and wealth had to be redistributed upward over this period – this upward redistribution was the result of deliberate policy decisions. The upward redistribution can therefore be reversed with a different set of policy decisions.

[2] According the OECD the average annual pre-tax income of doctors in the United States in 1995 was $196,000. By comparison, it reports that doctors in Switzerland earned an average $82,000, in Japan $57,300 and in Denmark $52,600 (Organization of Economic Cooperation and Development: Development Center. OECD Health Data, 1998. Paris: OECD, 1998). While these figures are now somewhat dated, there is no reason to believe that the relative wages have changed. This suggests that the average earnings of doctors in Europe is at least $100,000 less than in the United States. There are approximately 800,000 physicians in the United States, which implies that the savings from paying doctors at European wage rates would be close to $80 billion a year.

[3] The profit share of net income in the corporate sector was 20.1 percent in 1997, the profit peak of the last cycle. In 2005, the last full year for which data is available, the profit share was 19.7 percent (Bureau of Economic Analysis, National Income and Product Accounts, Table 1.14, line 8 divided by line 3).

[4] The two main views on the impact of immigration on wages are laid out by George Borjas and David Card. While Borjas’s research finds that immigration has had a substantial negative effect on the wages of less skilled workers, Card finds no effect of immigration on the relative wages of high school dropouts. A possible flaw in Card’s methodology is that he does not consider rents in his analysis. Many of the cities that have seen large inflows of immigrant workers have had sharp increases in rent over the last quarter century (e.g. San Diego and Los Angeles), while rent increases have been relatively modest in cities without substantial inflows of immigrants (e.g. Cleveland and St. Louis). Since rent is a very large share of the income of the lowest paid workers, it is reasonable to believe that if real wages were adjusted for the cost of living that workers actually face, there would be large differences in the trends in relative wages in cities with and without large inflows of immigrants.

[6] The air traffic controllers strike violated a federal law prohibiting strikes by federal government employees. However, such laws had rarely led to firings in the case of prior strikes by public sector workers.

[7] If an employer is found guilty by the National Labor Relations Board of having fired a worker for participating in an organizing drive, they must offer the worker her job back and give her the difference between the pay that she would have earned had she remained employed at her former job and the pay that she actually did earn at her new job. The Dunlop Commission estimated that this penalty averaged less than $3,000 per worker in 1990 (cited in Schmitt and Zipperer, 2007, page 3). Adjusting for wage growth, this would be close to $5,000 in 2007. This is a rather small price to pay for an employer, if it prevents a union from organizing, especially there is no guarantee that a fired worker will drag through an NLRB case, nor they will succeed even if they have been wrongly fired.

[9] It is important that developing countries be compensated for the loss of workers who in many cases the governments have paid to educate. It is easy to design policies that would assess some fee on the work visas granted to these workers so that developing countries could educate two or three professionals for every one that works in the United States. It is important to remember that the supply of highly educated workers in developing countries is virtually unlimited over time, if the government has the resources to educate them. A properly designed policy should ensure that developing countries gain at least as much as the United States.Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.